A bond is essentially a loan that investors make to the entity that issues the bond. The issuer of the bond agrees to pay a certain amount of interest according to a pre-set schedule and also agrees to repay the loan amount on a certain date.
The investor buys the bonds based upon these factors. If the bond is held to maturity (the date on which the principal is repaid) then the only risk is whether or not the company is able to make the interest payments and repay the bond, or if it defaults on payment, usually via bankruptcy.
A bond rating is a professional opinion on how likely it is that the issuer will be unable to fulfill its obligations under the terms of the bond.
Bond Rating Agencies
There are three main agencies that rate bonds, Moody’s, S&P, and Fitch. These rating agencies examine bonds that are issued and provide a rating for the bond issue based on a multitude of factors regarding the entity that issued the bond and its ability to make good on both interest payments and the eventual repayment of the bond issue.
Each rating agency provides its own ratings schedule and uses its own methodology to determine what rating it will assign a bond.
Knowing exactly what a specific bond rating means takes a lot of detailed understanding. Bond ratings can actually become very complex with Moody’s, for example, having 21 different ratings. However, things can be simplified by remembering some key points.
First, the more of a letter, the higher the rating within that category. For example, AAA rates higher than AA +. Pluses and minuses mean exactly what you think they would mean, but do not change the basic principal that more letters is a higher rating. Thus, A+ is a lower rating than AA-. (AA- has two A’s whereas A+ has just one A.) All things being equal this can help sort bond yields by ratings, higher rated bonds pay less interest and lower rated bonds pay more interest to account for the additional risk.
Second, the dividing line between investment grade bonds and junk bonds is BBB- or Baa3 for Moody’s.
Lastly, three A’s is the highest rating for all three agencies, Aaa for Moody’s and AAA for S&P and Fitch.
Bond Ratings Rating Table
This bond rating table can help with the rest of rating ranking complexities.
See How To Buy US Savings Bonds and Treasuries for related information.